Tax loopholes are really government spending by another name, experts say, and they cost the U.S. Treasury billions each year.

Takeaway

Loopholes, or "tax expenditures," cost the government $1 trillion a year.

Loopholes distort the economy by channeling investments into products and industries the market wouldn't necessarily support.

Tax expenditures are generally easier to pass than tax increases.

To Calvin Johnson, the trouble with the U.S. tax code can be summed up in four words: Grand Theft Auto IV.

“Grand Theft Auto IV is the most heavily-subsidized activity in America,” says Johnson[4], professor at the University of Texas School of Law, about the extremely popular video game. “We treat it, for tax purposes, as if it represents the highest American ideals.”

Because it’s computer software, he explains, the video game is entitled to several tax deductions and credits. It can deduct its entire cost of development in a single year (as “research and experimentation”), and along with 9 percent of sales revenue (for being made in America).

Unlike software and certain other intangibles (e.g., film and TV production), most products, from machines to CDs, are required to deduct development expenses over several years. This subtle distinction adds up to $50 billion of lost revenue annually for the U.S. Treasury, Johnson estimates.

Total up all the tax breaks for favored industries and Uncle Sam is losing at least $1 trillion a year, he says. That’s enough to cover most of the $1.3 trillion federal deficit.

Such tax breaks, loopholes, shelters, and subsidies are really government spending by another name, most economists say. Congressional budget rules call them “tax expenditures” and define them as, “Those revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.”

Sandy Leeds, senior lecturer in finance at the McCombs School of Business, describes the phenomenon more succinctly: “Whenever you give me some benefit, someone else is paying for it. So we’re just shifting the burden.”

The insidious thing about tax expenditures, says Leeds[5], is that they’re easier to pass than tax increases.

“A politician says he’s got an idea for a new program. If you want to spend money for it, people say, ‘I hate you.’ Instead, if you say you’ll do it by cutting taxes, then you’re a great American. Someone else is paying the taxes, but you’ve gotten votes.”

Loopholes Multiply

That’s why tax expenditures have proved to be the kudzu vines of tax policy. In 1986, the last time the tax code was significantly revised, many shelters were wiped out, in exchange for lowering the top tax rate from 50 percent to 28 percent. But new ones have grown back with each Congress. Today, they total more than 7 percent of gross domestic product.

What makes good politics makes bad economics, both professors agree. Besides padding the federal deficit, tax expenditures often cause unintended consequences. They distort the economy by channeling investments into products and industries the market wouldn’t support on its own.

Johnson cites one of the tax code’s most sacred cows: the home mortgage interest deduction. It benefits mostly the richest third of taxpayers, because they’re the ones who itemize, and the ones paying the highest rates. By deducting mortgage interest, a taxpayer in the 35 percent bracket can afford to spend a third more on a house than they would without the subsidy.

“It’s making people build far larger houses than they would otherwise,” says Johnson. “The only justification for a subsidy is to pay for things that the general public benefits from. With 5,000 square-foot houses, I don’t think the public in general would be willing to pay for it, if they knew what they were doing.”

Doing Away with Deductions?

Deleting the mortgage interest deduction, estimates the congressional Joint Committee on Taxation, would net the Treasury $94 billion a year. For Johnson, it’s just one of 64 tax expenditures he’s identified as expendable. With the help of other academics and tax lawyers, he oversees The Shelf Project[6], which makes a detailed technical case for each of the cuts.

The name comes from the notion that his proposals are sitting on the shelf, awaiting the day that some financial emergency forces Congress into fiscal reform. Says Johnson, “We have contingency plans for thermonuclear war, for Ebola in the subway system, for Russian tanks rolling across the German plains, but not for a real contingency like a financial crisis.”

With special-interest deductions stripped from the tax code, he says, government could raise extra revenue while lowering tax rates. Companies would have less incentive to use accounting tricks to hide income. Taxes, he says, should be “low, wide and unavoidable.”

A stint last year at a Washington think tank, the Tax Policy Center, left Johnson mildly hopeful that some proposals could come off the shelf. In recent months, both President Barack Obama and some Republican members of Congress have suggested trimming back some itemized deductions. But Johnson cautions, “I’m within a great consensus on the platitude level. Once you get down to the way people act, there’s not much of an independent constituency for it.”

For both scholars, the ideal is to eliminate as many tax expenditures as possible and use some of the new revenue to reduce the deficit. In a perfect tax code, Leeds would remove them all.

“I think we shouldn’t have tax expenditures, period,” he says. “I think that when any tax incentive leads us to change our behavior, we should argue that it’s inefficient. We’re not doing what we want to do, but what we’re incented to do. In addition, we lose all transparency when we spend taxpayer money in this way.”